The invention relates to portfolio construction and management, and more specifically, relates to methods and computer software applications for selecting and weighting securities in order to construct an investment portfolio, or an enhanced stock market index. The portfolio can be used to create a closed-end fund, a traditional mutual fund, a separately managed account, a unit investment trust or an exchange-traded fund (ETF). Additionally, an enhanced index may be used as the basis for an index tracking fund.
Professional investment managers often follow predetermined investment decision-making criteria or strategies for selecting the stocks for the portfolio. While the investment philosophies that inform stock selection strategies differ significantly, the strategies generally have two key inherent qualities:
1. Sound Analysis: The strategy seeks to out-perform specified indices by selecting portfolios by evaluating relevant, sound, fundamental and technical information that can reasonably be expected to be material to future returns. The spirit of this quality is captured by this quote from Benjamin Graham, mentor to legendary investor Warren Buffett:                The individual investor should act consistently as an investor and not as a speculator. This means that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money's worth for his purchase.        
2. Discipline: A rational investment decision-making process determines which stocks are chosen for the portfolio; emotional judgments should be avoided. Warren Buffett's words exhort investors to be mindful of irrational tendencies of human nature:                Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.        
Developing a strategy that robustly meets these criteria can be very difficult, if not elusive. The best of intentions are often thwarted because the stock market is subject to waves of optimism and pessimism. Fear and greed affect the market. Once again, Benjamin Graham states:                Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble give way to hope, fear and greed.        
In addition to greed and fear, which call the discipline of the investment process into question, various other behavorial biases can impede the other pillar of quality investment decision-making, sound analysis. One example is the “affect” bias, described here by prominent social psychologist Robert Zajonc:                We sometimes delude ourselves that we proceed in a rational manner and weigh all the pros and cons of the various alternatives. But this is rarely the case. Quite often “I decided in favor of X” is no more than “I liked X.” We buy the cars we “like,” choose the jobs and houses we find “attractive,” and then justify these choices by various reasons.This bias can result in the tendency to irrationally favor stocks with more familiar names in glamorous industries like fashion or technology and eschew boring industries like paper or chemical processing. Other examples are “overconfidence” where decision makers are overly confident in their own forecasts and “conservatism” where investors are reluctant to update their forecasts in response to new information. Overconfidence results in investors mistakenly believing that fundamental results such as earnings will fall into too narrow a possible range of values around their forecasts. Conservatism will result in investors being too slow to recognize a change in the direction of the underlying fundamentals of a firm, overlooking business turnarounds or steady declines in the face of obvious evidence of these occurrences.        
As discussed earlier, by their nature, human beings have great difficulty in selecting portfolios solely on the basis of well-reasoned analysis in a disciplined non-emotional manner. Objective, quantitative approaches based on intuitive financial theory and empirical evidence can mitigate the shortcomings of the human element in investment decision-making. Earlier quantitative investment strategies have been illustrated in U.S. Pat. No. 5,978,778 issued to O'Shaughnessy on Nov. 2, 1999 and U.S. Pat. No. 5,132,899 issued to Fox on Jul. 21, 1992.